Federal Reserve officials like to say their policy course is
“data-dependent.” That sounds very cautious and intelligent, but what does it
actually mean? Which data and who’s interpreting it? Let’s ask a few questions.

Photo: Federal Reserve Board
of Governors

First, how could their policy choices not be data-dependent? The only alternatives
would be that they made decisions randomly or that there was an a priori path already
determined by previous Fed policymakers that they were forced to comply with. A
predetermined path would, of course, eventually be leaked, and then everybody
would know the future of Fed policy. Until they changed it.

Of course, they do depend on data, and lots of it, but are they
looking at the right
data? If it is the right data, theoretically speaking, is it accurate? As we will see,
more often than not they are basing their decisions on data created by models
that rely on potentially biased assumptions derived from past performance, etc.
Often the data they look at is actually a sort of metadata, a kind of
second-derivative model, with all sorts of built-in assumptions, quite removed
from the actual data.

That approach is actually reasonable when you realize that the
amount of data that must be managed is simply too large for any human being to
process in a coherent manner. The data has to be massaged, and that means
making assumptions that create the models in the programs. Those are
assumptions are not made by computers, they are made by human beings who are
doing the best they can – using models based on assumptions they build in to
guide them as to what assumptions they should make about the data. Convoluted?
Yes.

I certainly don’t know all the answers to the problems with
national and global economic data and metadata management, and it’s far from
clear the Fed knows those answers, either. Whatever your economic and political
ideology, we can all agree that these are big problems. Today we’ll look at how
big.

First, a quick update on the Strategic Investment Conference. This
is especially for the many of you who wish you could attend but have conflicts.
For you, we have something new: the SIC Live Stream Virtual Pass.
Video coverage for all the conference sessions will be
streamed live over the internet straight to your
computer or mobile device! It’s not quite like being there, but
it’s darned close.

The technology to do this is quite expensive, as you may imagine.
We’re making the investment because this year’s message is so important. Our
theme this year is “Crossroads” because that’s exactly where the world is. We
are at an inflection point and have big choices to make. Right ones will speed
us along. Wrong ones could slow us nearly to a halt.

We are actually approaching multiple crossroads simultaneously.
You know the list: In addition to the Fed, other central banks are on the cusp
of big policy shifts, too. Geopolitical challenges are cropping up everywhere,
and some big emerging-market countries are on shaky ground.

We’ll be exploring those crucial issues and more at SIC with 25+
top experts. If you can’t join us in San Diego, the Live Stream Virtual Pass
will bring the conference to you. You’ll see all the sessions and even be able
to submit questions to the speakers.

I’m doing this because I want every reader to have every
opportunity to get ready for what’s coming. The SIC
Live Stream Virtual Pass will be your ticket, and at a very
reasonable cost.

Invisible Derivatives

Here’s a garden-variety mainstream media market narrative right
now. I made this up, but similar thoughts are voiced everywhere.

US growth is finally taking off after years of
stimulus. We’re near full employment, and wages are starting to rise. Consumers
are opening their wallets just as tax cuts and deregulation embolden business
to expand. At the same time, we are hitting resource constraints that have the
economy close to maximum output. The resulting concern about inflation is
pushing interest rates higher and taking some froth out of the stock market.

There are a lot of people who agree with this narrative,
especially those who talk to us via the mainstream media. The problem with that
story is that they are assuming facts that aren’t necessarily proven, two in
particular:

• We’re nearing full employment.

• The economy is close to maximum output, or “potential GDP.”

Are those statements correct? How do we know? How do we even define full employment and
maximum output? Measuring them isn’t like sticking a thermometer in your
holiday prime rib to see how it’s cooking (which, by the way, if you are
serious cook, you absolutely must be doing).

I thought about this problem with definitions last week when I
read a Washington Post
op-ed by Jared Bernstein. He was the chief economist for Vice President Joe
Biden and now works at a left-of-center Washington think tank. He’s also not
someone I would normally quote, since we are on quite different policy ground
politically and economically. But we also have some common ground, and I think
it’s important to note that. And for the record, more and more economists of
all stripes are beginning to come around to this very same view.

But Jared does
a particularly good job in a brief space of framing the issues. Here’s the lead
to Jared’s
article.

Recent events have exposed a hole in the middle of economists’
knowledge of key economic parameters: We
know neither the unemployment rate at full employment nor the potential level
of gross domestic product (GDP).

That hole is particularly important right now. The combination of
the deficit-financed tax cut and the new spending bill are pumping hundreds of
billions into an economy that many argue is already at full employment. If so, then much of this extra spending
won’t lead to new investment, jobs or higher real pay. When the
economy’s human and capital resources are fully utilized (meaning actual GDP is
equal to potential GDP), fiscal stimulus just generates inflation and higher
interest rates. Even if the extra demand might create some wage pressure, it
will be met with higher inflation, so real wages – the paycheck’s actual buying
power – won’t change at all.

The problem is that those making that argument are implicitly
asserting that they know that the “natural rate of unemployment” – the lowest
rate consistent with stable inflation – is roughly equal to the current
unemployment rate. That is, they believe we’re at full employment. But the
truth is they have no way
of knowing that, and one key indicator – inflation – suggests
they may be wrong.

Those are three paragraphs that I could have written and defended.
I think that fact is significant. Jared and I more than likely to disagree on
what economic policies we should follow – but we can’t even have that argument
until we can agree on what the data says and means. And we can’t at this point.
We have to rely on anecdotes and hints, at best.

This state of affairs is startling once you start thinking about
it. Economists are reaching conclusions and policymakers are making decisions
based on derivatives of invisible derivatives.

Sound crazy? Yes, but it’s happening.

Giant Mystery

Let’s talk about these two stats, full employment and potential
GDP. They have multiple layers.

“Full employment” means all the people who want to work are
gainfully employed. For the record, the Fed thinks that full employment is an
unemployment rate of about 4.7%, while the BLS tells us that unemployment is
currently running at 4.1%. Those who aren’t working are either in between jobs
or face some barrier, like a criminal record or lack of skills.

Therefore, if
we are indeed close to full employment, employers who need more help must offer
higher wages, which leads to inflation. At least that has been the pattern
historically.

But is it really that simple? In any given month, we have only a
rough approximation of how many people are unemployed and an even rougher idea
of how many might become employed but are currently not even looking. The
numbers come from survey data, with all the inherent limitations surveys
entail. There are actually two different federal surveys, and sometimes they
disagree wildly. Over time they get in line, but on a month-to-month basis?

Not
so much. Beyond those surveys, what we think we know is mostly conjecture and assumptions
about what we want the data to say.

For instance, simple observation and the actual surveys suggest
that many Americans, while nominally employed full-time, aren’t earning as much
as they once did. Nor are they as productive as they once were or as they could
be. If that’s a widespread pattern, it means the economy still has “slack.”
Production could rise significantly without adding any new workers. What we
have is not “full employment” in any real sense.

We use survey data to infer how many people are employed, how much
they are paid, and so on. In the process we observe people who aren’t employed. We try to
figure out why they don’t have jobs and what circumstances might bring them
back into the labor force. It’s a many faceted mystery no one has solved, yet
we make important policy decisions based on our fragmentary understanding of
that mystery.

Let’s look at a few different ways to measure what we mean by full
employment. The Bureau of Labor Statistics (BLS) suggests that if you
haven’t been looking for a job in the last 30 days, you are not in the
workforce. Thus you don’t count as unemployed.

First off, that way of defining unemployed
runs contrary to all of our personal experiences. There are lots of people who
have not been able to find a job and have given up looking, but if they were
offered a decent-paying job they would take it.

Choosing to say that they are
no longer in the labor force after just 30 days of not looking seems rather
arbitrary and unrealistic to me.

Now let’s take a look at the US labor force participation rate
since 1990 via the St. Louis Fed’s FRED database:

There are a lot of reasons for the participation rate to have
fallen so much, and the dropoff is an extraordinarily complex and difficult
thing to get your data head around. But policymakers and economists want to have
simple answers and solutions, so they make assumptions and then confidently
tell us that their assumptions are the correct ones: This is what the data
means. And they don’t bother to attach a 50-page white paper that parses all of
the different variables that go into making those assumptions about the
participation rate.

Just saying…

My friend Lance Roberts (via Michael Lebowitz) adjusts the
unemployment figure based upon a methodology that includes the people who have
quit looking for jobs. He compares that adjusted rate to the U3 rate in the
chart below.

Is Lance’s number the real
employment rate? I would suggest that it’s not, because a lot of people who are
not in the labor force really aren’t looking for jobs. They are students, or
they are on disability, and so forth. Lance performed the exercise to
make us think about the employment numbers.

If you argue that we are at “full employment,” then it follows
that you are expecting wage inflation. But that is not what we’re seeing.
Eighty percent of workers are seeing very little wage growth at all. This
instructive chart comes from my associate Patrick Watson’s latest Connecting
the Dotsletter:

For there to be demand-led inflation, consumers need to actually
have some of that wage growth in order to be able to spend more money. Yet real
savings as a percentage of disposable income is down to just above 2%, a long
way from the long-term average of 8%. And credit card debt is still rising
while disposable income is flat.

The first graph below shows the traditional Phillips curve as
typically displayed (U-3 and recent three-month wage growth). The second is a
modified Phillips curve which uses the revised U-3 from above and one-year
forward wage growth.

Both graphs … demonstrate that only 28.84% of the change in wages
was due to the change in the unemployment rate. Visual inspection [of the first
graph] also tells you the relationship between wages and unemployment is weak.
It is this graph that has many economists declaring the Phillips curve to be
irrelevant. The second graph has a (warning: economic geekspeak) statistically
significant R² of .7047 and a visible confirmation that the Phillips curve
relationship continues to hold. Recently, Federal Reserve Bank of Chicago
President Charles Evans stated, in relation to the Phillips curve, “We don’t
have a great understanding of why it’s gotten to be so flat.” Mr. Evans,
perhaps employment is not as strong as you and your Fed colleagues think it is.

720 Global goes on with more math before they produce this
important graph:

If one believes that the laws of supply and demand continue to
hold true, then the revised Phillips curve graph above argues that the
unemployment rate is in reality much closer to 9% than 4.1%. To believe that
the Phillips curve is useless, one must be willing to ignore a more rigorous
assessment of labor market and wage data. The only reason economists and Fed
officials voluntarily ignore this data is that it belies the prettier picture
of the economy they wish to Paint.

Does anyone else see a problem here? Those who crunch the data see
what they want to see and disregard the rest. If you want to see low
unemployment, you find data that gives you low unemployment. You don’t look at
contrary measures.

The Fed has taken this position in spite of the fact that most Fed
economists truly believe in the Phillips curve. They just don’t believe in it
enough to take it to its logical conclusion, as 720 Global did.

Then there’s “potential GDP,” or the nation’s theoretical maximum
noninflationary output. What does it tell us? First, note that we barely have a
grip on actual
GDP, even though it is a function of (mostly) observable data. A small army of
people spend their entire careers collecting GDP inputs. They do a fine job,
too; but no one really knows if they are collecting the right data to support
the conclusions everyone draws. Further, GDP does not measure all the things
that we used to buy at significantly higher prices, which contributed to GDP
but are now (for instance) available in our phones for “free.”

I have spent entire letters talking about the limitations of GDP
measurement. I thoroughly understand why we must have the measure, but we need
to recognize what it is and isn’t. It is not a meaningfully, accurate number
delivered from Mount Olympus by the economic gods. It is, at best, a
concatenation of approximations, the movement of which, based on those
approximations, can give us insights into the economy – but not with any real
precision. Google Maps gives you very precise directions. The GDP number is more
like “We are going west; we are not going north.”

We then use this estimated GDP, this fuzzy and incomplete growth
measure, to infer potential
GDP, or how high this nebulous number could go if some of its inputs changed.

Then we wonder how close we are to this vague derivative of an incomplete
measure of a hypothetical construct, so that we can modify fiscal and monetary
policies. It’s important to understand that if we have in fact now begun to
exceed our potential GDP, then economic theory suggests that inflation – and
perhaps not even mild inflation – is right around the corner. I am not a
doctorate-holding economist, but to me this seems an unwise assumption to make.

Others think so, too. Here’s Jared Bernstein again:

It’s true that influential institutions such as the Federal
Reserve and the Congressional Budget Office (CBO) believe that the “natural”
unemployment rate is above the current one, meaning our labor force is beyond
fully employed. Their estimates are 4.6 percent and 4.7 percent, respectively,
while the actual rate is 4.1 percent. The CBO also asserts that our current
level of GDP – $19.7 trillion – represents full capacity.

But the evidence undermines much confidence in these
authoritative-sounding point estimates. First, understand that neither of these
measures – the natural rate or potential GDP – can be observed. They must be
estimated based on the movements of other variables. For example, the key
relationship underlying the natural rate is the one between unemployment and
inflation, with the basic insight being that once economic capacity is
exhausted, any more demand just shows up as more inflation (note the link
between the debate over fiscal spending right now).

This is a key point. No one can directly observe the natural
unemployment rate or potential GDP. “They must be estimated based on the
movements of other variables,” Bernstein says. Much of our economic data is
similarly inferred.

Astronomers can look into the heavens and infer that planets they
cannot see are revolving around stars they can see. They can do this because
they understand with some precision how gravity works. Moreover, gravity
doesn’t sometimes work differently because people wish it would. Wile E. Coyote
kept learning this the hard way. Economics enjoys few such certainties, even
though many economists think it does, or at least wish it did.

Zero Confidence

This brings us to the present market conundrum. Is the economy
close to overheating, or not? Perfectly sincere people look at the same data
and come to radically different answers. That wouldn’t happen if economics were
a hard science. We would apply the data to known laws and the correct answer
would be obvious. It isn’t obvious at all, but policymakers act like it is.

I’m not saying we should go to the other extreme, doing nothing
until we have 100% certainty. That’s not wise, either. The key is to recognize
that we have blind spots and then work around them. For instance, physicians
don’t know everything
(certainly not as much as we like to believe they do) about the human body, but
they make good use of what they do know. The lab tests show an infection, and
they treat it; the CT scan shows a suspicious mass, and they remove it.

Would you let a doctor cut you open based on data as reliable as,
say, GDP or unemployment? Of course not. That would be crazy. And your doctor
would probably agree, because the Hippocratic Oath says “Do no harm.”
Economists have no such oath. Maybe they should.

Airplanes are an even better example. Your pilot delivers you to
your destination safely thanks to extensive, accurate data on the plane’s
course, altitude, speed, and so on. Now imagine a plane in which Federal
Reserve staff had filled the cockpit with instruments meeting their standards.
Would you get on that plane?

Let me think for a nanosecond. No. I would not board such a plane
because I would have zero confidence that it was taking me to the right city. A
San Francisco flight could easily end up in Cleveland – if it arrived anywhere
at all without crashing.

All this is very obvious to people who lack graduate degrees, yet
for some reason the economics profession persists in thinking it knows things
it simply does not.

Economists have physics envy. They want their profession to
be a hard science, when it is probably one of the softer of the soft sciences.

Believing that the data they have is precisely meaningful gives
people like Federal Reserve governors the mistaken impression that they have
what they need to manage the economy successfully. They don’t. They have lots
of data and not so
much information.

Our best move is thus to admit the uncertainty, toss the point
estimates, and follow the data, particularly inflation. Recognize that we’re
driving a car with no reliable indicators of engine overheating, so we’ve got
to use our eyes and ears to gauge the heat. That doesn’t call for recklessly
pumping the gas or the brakes. It does call for more humility about the limits
of our knowledge.

Having “more humility about the limits of our knowledge” would be
an excellent step toward more rational monetary policy. Will the Powell Fed
take that step? I hope so… but I’m not holding my breath.

Think about this: 12 people sit around a table, chew the fat over
masses of data and metadata, and then set the price for the most important
commodity in the world: the US dollar, the world’s reserve currency. How do
they know they’re right? Well, they tell us confidently, it’s all in the data.

If the market is competent to set long-term rates or LIBOR, then
maybe we should trust the market to set short-term rates. That doesn’t mean
there would be no role for the Fed. There are points in the economic cycle when
the Fed can be quite useful, typically during a liquidity crisis that follows
hard on the heels of too much irrational exuberance.

Want to have some fun? Read
this at the Financial
Times Alphaville site. A former Fed insider recounts the debate at
the FOMC meeting when the committee was trying to implement QE3. It’s hilarious
in a sort of “Oh my God, it can’t really be this bad can it?” way. Not exactly
confidence-inspiring. And yes, I’ve talked with lots of people who have been
“in the room,” and it can get that bad.

And yet the chairman of the Federal Reserve comes out after the
meeting and confidently announces whatever the policy decision is, not
mentioning the questions and disagreements and uncertainty and frustration of
the members who sat around the table. By the way, these FOMC meeting minutes
are not released for five years. I guess that’s because the parents don’t want
to let the children hear them arguing.

And with that I will hit the send button. Technically, I should
have spent a good deal of time talking about inflation and the CPI in
conjunction with this question of the analysis of data, but the letter is long
as it is. Next week we will spend the entire time talking about inflation and
the assumptions we make about it. That’s an exploration I look forward to
sharing with you.

Sonoma and the SIC in San
Diego

I will be meeting with Mauldin Solutions business associates
Sunday night through Monday night; then Tuesday morning I’ll fly off to San
Francisco and then drive up to Sonoma to be with my friends at Peak Capital
Management for their annual client conference. It will be a fun conference, as
I have a lot of friends flying in. I’ve been wanting to spend some quality time
with them. Peak has graciously allowed me to stay a few days, and I am going to
bookend their conference.

After that conference I am home for a week to nail down my
presentations at the Strategic
Investment Conference in San Diego. I mentioned at the beginning that we
are doing a video live stream of the conference. Some of the links we used when
first sending that information out did not work. I am assured that this one
does: SIC Live Stream Virtual Pass.

It’s the next best thing to being there. By the way, I didn’t
mention it above, but you will be able to go online and ask questions and vote
on the questions that those in the room are asking. We are doing everything to
make the Virtual Pass as close to the real thing as possible.

Sidebar: It happens every year. This is our 15th
conference, and for the last seven or eight in particular we have gotten a lot
of people who should be on the stage signing up at the last minute. Last year
and this year I kept a few sessions open, waiting to see who would show up that
I should ask to join us as presenters. But no sooner had we finally “pulled the
trigger” this year than we had several people sign up that I wished we had on
the stage. Oh well, maybe next year. But for those who are attending, I will
point them out from the podium so you can catch them at breaks and dinners.

Have a great week. Shane and I are going to try to relax for a day
or so while we can, because life gets really busy for the next three weeks,
without a lot of opportunity for breaks. People around me tell me it’s
important to take breaks. I have not been very good at that over the years, but
I’m going to get better. After I get back from the gym…

US economics is extremely predictable. It doesn’t matter who is President and what party he comes from. Because every president will spend more money than the US can afford. On average, US Federal debt has doubled every 8 years since Reagan came to power in 1981. And Trump has just fulfilled the prediction. The budget deal that has been agreed is guaranteed to produce substantial deficits in coming years. The current year’s deficit might be just under $1 trillion but thereafter it is virtually guaranteed that the US will not have a budget deficit under $1 trillion for many, many years.

US Federal Debt $40 trillion by 2025

During Obama, debt went form $10T to $ 20T. Whether Trump will manage to keep it below $28T by 2021 is questionable. What is more certain is that by 2025, whoever is president, debt will most certainly fulfil the historic trend of doubling every 8 years. That means a $40T debt in 2025.The scenario to cause this huge debt is straightforward. Crashing bond and stock markets, high interest rates, high inflation leading to hyperinflation and defaults in the financial system. All that will result in massive money printing on a scale that has never been done in history. It would actually be a miracle if the US debt is only $40T in 2025. With hyperinflation, it could be multiples of that sum.

Bubbles are bursting

The signals that the markets have given in the last few weeks are a clear indication that the euphoric stage of the economy is coming to an end. It began with the biggest bubble in history starting to burst – Cryptocurrencies. In one month the market cap of this market more than halved from $835 billion to $395 billion.Cryptos have been a wonderful speculation for the few that managed to cash in. But for many it has been a disastrous Ponzi scheme that will end in tears. Cryptos have nothing to do with real investments and even less to do with wealth preservation. There is nothing wrong with having a small flutter in a speculative instrument. Sadly though, many buyers of cryptos have been tempted to buy on credit and are sitting on major losses.

The fall in Cryptos is symptomatic of the end of an era. Compared to $80 trillion global stock markets, cryptos are insignificant. Stocks and cryptos have one thing in common, they both have a long way down from here. Whilst cryptos will go to zero, stocks will go down in real terms by at least 90%. I say real terms because hyperinflation can take the nominal level of stocks a lot higher. Between 1929 and 1932 the Dow fell by 90%. On any criteria, the stock bubble is so much greater today so once this market has topped, the coming fall will shock the world.

Stock market investors have had the most fantastic ride for over 100 years. $100 invested in 1913 when the Fed was created would today be worth $2.8 million. That assumes all dividends reinvested and no tax paid. This is a remarkable return and only achieved thanks to a group of bankers who decided to take control of the Western world’s financial system in 1910 on Jekyll Island. This was one of the most remarkable financial coups in the financial history for the world. As the famous banker Mayer Amshel Rothschild said over 200 years ago: “Permit me to issue and control the money of a nation, and I care not who makes its laws”.Since the Fed was created in 1913 for the purpose of controlling the money, Global Debt has gone from virtually nothing to $250 trillion today. Add unfunded liabilities of $250 trillion and derivatives of $1.5 quadrillion and we are looking at a total risk for the world economy of $2 quadrillion.

A mere 1% increase in rates will create a blood bath

Governments and central banks have mortgaged the future for generations to come. Nobody must believe that this money will ever be repaid or that the liabilities can be met. Thus, there will not be an orderly outcome of the greatest financial bubble in history. Central banks are now reversing their expansionary policies. The combination of tapering and interest rate hikes are guaranteed to pop the bubble. The global economy is totally dependent on their daily dose of fresh money and zero interest rates. A 1% increase in interest rates would according to the US Treasury’s Office of Financial Research (OFR) lead to a bloodbath in the US high-grade bond market. This would then spread to junk bonds, fixed rate mortgages and derivatives to further spread the crisis. A rise in rates will also affect the offshore dollar funding market which has risen 5 fold this century to $10 trillion. With over Yen 1 quadrillion in debt, Japan could not survive rates rising above zero.The OFR Stress Index below is a daily market based snapshot of stress in global financial markets. It is constructed from 33 financial market variables such as yield spreads, valuation and interest rates. The index is now at a similar risk level as before the 2007- 9 financial crisis.

Risk is at an extreme

As I have discussed in recent articles, risk is currently at an extreme in most sectors of the financial world. The main indicators which are now signalling a turn in markets are interest rates and inflation going up and the dollar falling. These moves will accelerate in coming months and years until we see both interest rates and inflation in the teens, at least, and the dollar finishing the 100 year move to zero.

The volatility in stock markets that we have seen in recent days is another indication of a turn in the economy. In 5 of 6 trading days last week, the Dow moved 500 to over 1,000 points per day. We are likely to see further pressure in the short term before either the market turns up again to finish the melt-up move sometime this year. Or alternatively we have now seen the top and markets move down strongly from here. Either way, stocks are now very high risk and investors should either reduce positions or get out of the market.With stocks falling and cryptos halving in value, the precious metals are now starting to react. As is common when stocks fall, metals also go down initially before they resume the uptrend. Gold in dollars is now up $120 since early December. For gold to really move, it must move in all currencies. But that has not been the case. Gold in Euros, Swiss francs and Pounds are just slightly above the early December levels. This means that it is actually not gold which has moved up since December. Instead, what we have seen is dollar weakness.A strong gold move up in all currencies imminent

Thus dollar based gold investors have benefitted from the move since December but not investors in other currencies. For the last two years, gold in Euros has traded in a narrow range of EUR 160 between EUR 1,060 and 1,220. In the last 6 months this range has narrowed further and gold in Euros is now poised for a breakout to the upside above EUR 1,200. When that move starts, gold is likely to move up not just against the Euro but in all currencies.

Silver will lead the metals to new highs

The Gold / Silver ratio is often a good indicator of the direction of the precious metals. This ratio has now reached just above the 80 level for the fourth time this century. Every time the ratio has reached the 80 level there has been a sharp reversal. Looking at the chart, a reversal is likely within the next few weeks. That will result in silver taking the lead and moving up fast with gold following at a slower speed. So it is probable that silver will soon start the move to new highs, providing major capital appreciation combined with excellent wealth preservation. But it must be physical silver since there are likely to be major shortages once the move starts.

Swiss refiners are reporting solid demand for gold. As usual most of the buying is coming from the East and China in particular. There is a constant demand for the 3,000+ tonnes of gold that is produced by the mines, mainly to the East. Once the paper gold market fails, which could start in 2018, the current gold price will never be seen again.

2007- 9 – Here we go again2018 is likely to be the year when the 2007-9 crisis returns with a vengeance. But this time it will be a lot more serious. Central banks will panic and print money at a level never seen before in history leading to collapsing currencies and hyperinflation. The time when gold and silver can be bought at current low prices is soon coming to an end and at some point it will be virtually impossible to find precious metals at any Price.

LONDON/WASHINGTON, DC – At this year’s World Economic Forum meeting in Davos, Switzerland, participants did not question the basic building blocks of growth in today’s global economy: free markets, good governance, and investment in human capital and infrastructure. But they did criticize how unfairly the benefits of growth are being distributed. Rightly so: without a strong policy response aimed at building a more inclusive growth model, rising populism and economic nationalism will impair the functioning of markets and overall macroeconomic stability – potentially cutting short the current global recovery.Virtually every economic policy has an impact on both aggregate income and its distribution. Some reforms – such as those promoting impartiality and efficiency of legal institutions – are good for growth and equity (in this case, equality of opportunity). Incidence results for deregulation of product and labor markets are more mixed, possibly as a result of data limitations and the specific circumstances of each reform.By contrast, when it comes to financial deregulation and the liberalization of international capital flows, there are clear equity-efficiency tradeoffs: they boost growth, but they also tend to increase inequality. The evidence points in a similar direction for some measures aimed at liberalizing current-account transactions (trade in goods and services).These findings should not come as a surprise: it is well-known that rapid technological change and globalization have contributed immensely to the creation of a winner-take-all economy, in which those with a first-mover advantage accrue a disproportionate share of the benefits of growth.Policymakers’ task is to ensure that the disadvantaged also have opportunities to succeed in the modern economy, by designing all reforms and other measures with an eye to their distributional effects. Otherwise, pro-growth reforms will lose political legitimacy, enabling destructive nationalist, nativist, and protectionist forces to continue to gain traction and thus to undermine medium- and longer-term growth.The key to success will be to take preemptive action, rather than focusing solely (or even primarily) on ameliorative measures. This means designing coherent policy packages that internalize the distributional effects of supply-enhancing policies, and that aim to create a better balance of winners and losers across those policies. In our work for the World Economic Forum’s Global Future Council on Economic Progress, we have produced a list of concrete actions that would advance such an agenda.The first critical area of focus is skills training, skills upgrading, and addressing job displacement. Globalization and the so-called Fourth Industrial Revolution have increased the pace of change in labor markets, putting a premium on adaptability. Public policies have a role to play not only in providing a cushion for workers in transition, via income support, but also in creating incentives and opportunities for skills acquisition.To this end, governments should boost investment in life-long learning to retrain, retool, and reskill. For example, governments could use individual skill accounts to provide training grants throughout people’s working lives, conditional on stronger private-sector involvement in training and skills development. Governments should also reinforce the supply of skills by strengthening incentives for educational institutions to harness the power of digital technology and new business models.A second critical area is taxation and social protection. While the specific policies would vary according to national social contracts, our work suggests that redistribution – unless extreme – does not bring salient efficiency losses. Moreover, the greater equity it brings serves to make economic growth more sustainable, such as by reducing systemic fragilities that can lead to sharp downturns.When it comes to taxes, it is critical to safeguard the growth model’s political legitimacy by ensuring that the system is not skewed in favor of the wealthy. Beyond increased taxation of rents and estates, policymakers should pursue cooperative efforts to stem corporate tax avoidance, tax inversions, and the use of tax shelters. Fiscal transfers should also be better targeted, in order to protect the most vulnerable groups.Similarly – and this is the third critical reform priority – more aggressive action is needed to regulate financial markets, especially to prevent insider trading and money laundering, and to close down illegal financial centers. Cross-border regulations and measures are also needed to ensure that risk-takers bear an appropriately high cost for recklessness. More generally, countries need to avail themselves of the tools at their disposal to manage cross-border capital flows, with the objective of mitigating the risk of financial crises and their associated fiscal costs.The fourth and final priority is a more concerted effort to ensure fair competition and avoid crony capitalism. Guaranteeing a level national playing field and a rules-based international order requires effective competition policies and enforcement of fair-trade rules. Whether in industry, services, or the media, anti-trust actions to avoid capture of institutions or industries – by the powerful or the state – are vital to support inclusiveness.The backlash against globalization – and, in some cases, against capitalism itself – demands economic policies that not only address problematic distributional effects, but also preempt them. This will require a fundamental change in mindset, with businesses and governments alike recognizing, at long last, that growth can be sustainable only if its benefits are broadly shared.The decision to place inequality at the center of the discussion at Davos this year was a promising development. But actual solutions remain undeveloped. Despite expressions of anguish about widening economic disparities within many countries, policies to address them remain inadequate. This must change if the current economic recovery – the source of so much relief and hope around the globe – is to continue.

Sergei Guriev is Chief Economist at the European Bank for Reconstruction and Development. Danny Leipziger, Professor of International Business at George Washington University and Managing Director of the Growth Dialogue, was a vice president of the World Bank and served as Vice Chair of the Spence Commission on Growth and Development.Jonathan D. Ostry is Deputy Director of the IMF's Research Department. His most recent book is Taming the Tide of Capital Flows.

But those hoping for a great acceleration in the economy will be disappointed

Matthew C. Klein

The famed “bond vigilantes” are clearly unconcerned about the government’s ability to fund its debt issuance. The US government’s real long-term borrowing costs are lower now than they were at the beginning of 2016.That is not what you would expect if traders were exercised by the prospect of large future budget deficits, nor is it what you would expect if traders were optimistic about the growth Outlook.There is also useful information in the absolute difference between shorter and longer-term real yields. If 10-year yields are higher than five-year yields, for example, then that probably means traders expect some combination of faster growth and tighter monetary policy in the future relative to today.During the worst of the crisis, the real yield curve was deeply inverted — real 10-year rates were about 1.5 percentage points lower than real 5-year rates. By early 2010, the prospect of monetary and fiscal stimulus had pushed 10-year real rates about 1 percentage point above 5-year real rates. This spread stayed around that level until the end of 2013. In the past year it has collapsed to zero.This curve flattening does not necessarily mean recession is imminent, but it also suggests the future will not be much different from the way things are right now. Market pricing implies those hoping for a great acceleration will be disappointed. The better future promised in the past has already arrived.

BlackRock sees an opening in the massive amount of money looking for a home, but that should worry investors

By Aaron Back.

BlackRock hopes to stand out from the private-equity crowd by adopting a longer time horizon and by cross-selling its new investment product to its huge, existing client base that includes some of the world’s largest asset owners. Photo: Michael Nagle/Bloomberg News

The king of passive investing is making a foray into private investments. While the move by BlackRock makes some sense strategically, it also may be the latest indication of froth in financial markets.BlackRock is an investment industry champion with a stellar track record of gathering assets, based largely on the strong trend toward passive, low-cost strategies. Last year they pulled in record net inflows of $367 billion.

So it is a bit of a head scratcher why the company now feels the need to raise an additional $10 billion on the side to buy and hold stakes in companies, as The Wall Street Journal reported Wednesday. This will put them into direct competition with the likes of KKR, former parent Blackstone Groupand indeed Berkshire Hathaway, to whom BlackRock compared its new approach. That is some distance away from BlackRock’s core competency.

NO SHORTAGE OF ASSETSBlackRock´s Assets under management

The apparent answer is that the money is out there for the taking. Total private-equity dry powder, or money sitting in funds waiting to be invested, exceeded $1 trillion at the end of last year, according to Preqin. That is up from just $560 billion five years earlier.BlackRock Chief Executive Larry Fink may also figure that with equity and debt markets currently at very high levels globally, now is a good time to diversify into private-equity investments that face less near-term pressure to perform.BlackRock hopes to stand out from the private-equity crowd in a couple of ways. One is by adopting a longer time horizon. The firm plans to hold investments for more than 10 years, the Journal reports. That is significantly longer than the typical private-equity fund; hence the firm’s comparison of itself to Berkshire Hathaway. A second way is by cross-selling this new investment product to its huge, existing client base that includes some of the world’s largest asset owners.One can’t begrudge BlackRock for putting out its hand for a small slice of the money on offer. Even if the experiment somehow goes awry, it won’t make much of a dent in a company with $6.3 trillion of assets under management.But the sheer imbalance between the supply of investable funds and suitable outlets for investment that gave rise to this move should ring some alarm bells for investors generally. At market tops when money is desperate to find a home, it often winds up in places it shouldn’t.

The Turkish military said on Feb. 6 that one soldier was killed and five more were wounded in a mortar attack while attempting to set up a military outpost in northwest Syria. The Turkish military statement did not include any details about who had attacked its soldiers, but Arab News – an English-language daily based in Saudi Arabia – claimed that the attack had been carried out by “Iranian militias.” A Saudi media outlet has an interest in playing this up, but various other reports simply noted that “pro-regime forces” had carried out an attack on Turkish forces. Either way, Turkey and Iran are on a collision course.

The two countries started down this path after Iran and Russia supported an offensive by Syrian President Bashar Assad’s regime into Idlib province, one of the de-escalation zones whose security Turkey was supposed to guarantee. That offensive, and the regime’s apathy in response to repeated Turkish objections, forced Turkey’s hand and resulted in last month’s Turkish incursion into Afrin. Despite stiff resistance, the incursion is making steady progress, to the extent that Turkey has been trying to set up a military outpost southwest of Aleppo for more than a week.

Turkey has already clashed with pro-Assad regime forces in this same location. On Jan. 29, a Turkish convoy of almost 100 armored vehicles, backed by the Turkish air force, attempted to establish a position between pro- and anti-Assad regime forces southwest of Aleppo. According to the Institute for the Study of War, the convoy met heavy resistance from Assad regime forces, halting the initial Turkish advance. At the time, the only report out of Turkey came from the Turkish General Staff, which noted that a Turkish soldier and a civilian support worker had been killed by a car bomb attack on a military convoy.

The Assad regime has consistently criticized the Turkish incursion without doing much about it. Aside from a few small-scale attacks and some leaks to Reuters claiming deployment of “new air defense and anti-aircraft missiles,” Assad’s forces have focused more on repositioning to defend Aleppo than on directly engaging Turkish forces. This was in part because Turkey’s incursion did not pose an immediate threat. The invasion of Afrin was beneficial to Turkey, however, because it allowed Ankara to connect previously isolated anti-Assad rebel groups and also put Turkey in a better position to threaten Aleppo directly should Assad continue his advance into Idlib. This was not an ideal circumstance for Assad by any means, but it was a limited incursion within tolerable boundaries.

Turkey’s recent moves in southwest Aleppo are more ambitious than the initial incursion, as they are increasing the threat to Assad forces. The position the Turkish military is reportedly attempting to establish is well outside of the Afrin region. The Kurdish-dominated Afrin region does not extend all the way to Aleppo; the regional capital, also named Afrin, is about 23 miles (37 kilometers) north of Aleppo. But Turkish forces have pushed well beyond this, reportedly attempting to establish an outpost in al-Eis, a Syrian town of roughly 5,000 that is about 12 miles from Aleppo – but southwest of the city. Furthermore, al-Eis is not in Idlib province – where Iran and Russia had agreed, at least in principle, that Turkey should be responsible for security – but in Aleppo province itself.

It makes sense, then, that the Assad regime and its Iranian backers have twice attacked this extension of Turkey’s incursion. Taking Afrin meant shortening the distance from Turkish territory to Aleppo. Setting up an outpost in al-Eis means preparing for a potential assault on the regime’s position in Aleppo. This is why Iran, in particular, has reacted with such hostility to Turkey’s recent moves, with President Hassan Rouhani saying on Feb. 5 that Turkey had flagrantly violated Syria’s sovereignty, and Iran’s foreign minister saying that Turkey’s actions were creating “insecurity, instability, and terrorism.”

Silence From Russia

Noticeably quiet in this squabble-turned-shelling is Russia, without whose tacit approval Turkey could not have entered Afrin in the first place. (Russia still controls the Syrian skies and would have had to approve any Turkish air deployments across the border.) Russia had a fighter jet of its own shot down by Syrian al-Qaida last week and in response has intensified air raids on jihadist targets in Idlib province. But Russia has not gone so far as to denounce in public Turkey’s invasion of Afrin. Still, Russia may very well have given equally tacit approval to Assad and Iran to attempt to block Turkey from ensconcing itself so far into Assad-controlled territory and so far outside of the stated purview of its Afrin operation. (It also bears mentioning that Turkey has carried out fewer airstrikes this past week, perhaps indicating Russian disapproval behind the scenes.)

On the one hand, Russia gains from all of this. It has decent relations with Turkey and an even stronger partnership with Iran, but that is an ephemeral state of affairs. Russia has long-term problems with both. The more Turkey and Iran are focused on competing with each other, the less focused they are on competing with Russia. Still, this is too much, too soon from the perspective of Russia, which is relying on a diplomatic settlement to the Syrian civil war so it can withdraw its military assets from the country in glory. Bringing home a fighter pilot in a coffin, watching its trade mission get bombed in Damascus and seeing the situation on the ground around Aleppo deteriorate to this extent was not part of the plan, and might necessitate new and more substantial Russian commitments to protect Assad.

None of this is a foregone conclusion yet. Turkey can still pull back, or at least reach a tense if workable arrangement with Assad and Iran about drawing temporary borders that satisfy the interests of both sides. But military operations like this, once underway, begin to take on a momentum of their own. All it takes is one serious miscalculation of the other side’s intention for a minor skirmish to turn into a more significant battle that would be hard to walk away from. Our view had been that 2018 would not be the year Turkey and Iran confronted each other directly; we expected their partnership, however uneasy, to continue throughout the year. That forecast is now being put to the test.

Unless the U.S. military does something to stop it (and maybe even then), North Korea is going to become a full-fledged nuclear power, a fact that is stressing the U.S. alliance structure in Northeast Asia. Whether the U.S. decides to attack or learn to live with it, its decision could undermine America’s credibility with its two stalwart partners in the region, Japan and South Korea. And with North Korea on the path to being able to strike the U.S. mainland, the question is looming larger whether the U.S. can be trusted to respond to an attack on Japan or South Korea even when doing so puts U.S. cities at risk.

The U.S. alliance structure could evolve a number of ways over the coming decades. But when examining the degree to which Japan and South Korea will continue to put their faith in U.S. security guarantees – or whether each country could fully break from the U.S. alliance – there’s one inescapable variable: the willingness of either country to continue forsaking nuclear weapons in a region that’s about to be swimming with them. Currently, both countries rely fully on the U.S. nuclear umbrella. Neither wants to find itself holding a knife in a nuke fight.

To develop and sustain a nuclear deterrent, a country needs five things. The first is the capability to build a nuclear weapon. This includes both technical expertise and the ability to procure fissile material. The second is the military capability to ensure that it can deliver a nuclear weapon in what is likely to be an unpredictable combat environment. Overcoming the first two obstacles is exceedingly expensive, meaning the country also needs the economic resources to invest in the nuclear program and accompanying delivery systems in perpetuity. Fourth, it needs sufficient public backing, given that decisions to “go nuclear” often generate major domestic concern about the economic and moral costs of the program, the very real risk of accident and the potential that the effort could backfire and put the country at risk of annihilation. Finally, the decision must be rooted in strategic rationale strong enough to outweigh the risks of international blowback, which can range from isolation and economic sanctions to attempts to halt the nuclear program by force.

This Deep Dive does not seek to make a firm forecast on whether either Japan or South Korea will pursue nuclear weapons. Rather, in an attempt to gauge a key component of the resilience of the U.S.-led security framework in the Western Pacific, it focuses on how well-equipped both Japan and South Korea are to overcome these five hurdles should they be compelled to do so. It concludes that both countries almost certainly have the technical and scientific capabilities to develop a bomb quickly, possibly in less than a year – though building out a robust arsenal, plus the weapons infrastructure needed to ensure delivery, would take longer, particularly for Japan. As sophisticated, stable and wealthy economies, both also could sustain the budgets needed to do so. Public support is a bigger hurdle in Japan than in South Korea. And the strategic rationale would depend on the size of the breach with the U.S. and whether they determined that the status quo had become fundamentally untenable.

As could be expected given its history, nuclear weapons are an extremely sensitive issue in Japan. Partially as a result, Japan has not made any serious effort to develop its own nuclear arsenal since becoming the only country ever to be attacked with a nuclear weapon at the end of World War II. Instead, the alliance with the U.S. has been the cornerstone of Japanese strategic doctrine, with the country sitting firmly beneath the U.S. nuclear umbrella.

Today, the U.S. does not store nuclear weapons anywhere on Japanese soil, but Japan is well-covered by all components of the U.S. “nuclear triad” – where nuclear devices can be delivered from submarines, land-based silos and stealth aircraft – stationed far from Japanese shores. Any leg of the triad could conduct a retaliatory strike on Japan’s behalf following a nuclear attack launched by any adversary in the region.

Japanese leaders have been known to float the possibility of going nuclear during periods of heightened regional tension, but Japan has generally been content to depend on the U.S. for nuclear deterrence, along with most conventional military needs. Doing so enabled Japan to focus resources on rebuilding the country after World War II and on forging a dominant, high-tech economy. Nonetheless, Japan almost certainly could develop and deploy its own nuclear arsenal if it felt the need to do so, possibly within just a few years. This is why Japan is sometimes referred to as a paranuclear, nuclear threshold or nuclear latency state.

Building the Bomb

Japan’s latent ability to develop a nuke is rooted in the fact that it has a highly advanced economy, a burgeoning arms manufacturing base and a well-earned reputation for pioneering the cutting edge of scientific and technical advancement. Most important, Japan – an archipelagic nation with scant energy resources of its own – has had little choice but to build out a sophisticated civilian nuclear power system. Before the 2011 Fukushima disaster, Japan had 54 nuclear power reactors in operation, the third most in the world behind only the U.S. and France. (Following the tsunami, everything was taken offline, but 11 were back in operation by the end of last year, and 12 more have been approved to restart.) In 2012, Japan updated its Atomic Energy Basic Law to describe its civilian nuclear power program as indispensable to its national security, a move that hints at Tokyo’s desire to preserve its nuclear latency.

One byproduct of the emphasis on nuclear power is that Japan is the only non-nuclear weapons state with a large stockpile of separated plutonium. To reduce its dependence on imported enriched uranium, Japan has been focusing on “closing” the nuclear fuel cycle, which involves reusing plutonium extracted from spent fuel. Perhaps most alarming to its neighbors, this separated plutonium can be near-weapons grade. (The U.S. proved in the 1960s that reactor-grade plutonium could be weaponized.) As of 2010, according to the International Atomic Energy Agency, Japan had 10 tons of separated plutonium stored domestically and another 37 tons in France and the United Kingdom (where it is sent to be reprocessed), and it plans to open its own long-delayed reprocessing site this year, even though none of Japan’s nuclear reactors currently online are capable of using reprocessed plutonium as fuel. The Nonproliferation Policy Education Center, or NPEC, says Japan’s stockpiles are already enough to build as many as 6,000 nuclear warheads.

To what degree Japan has the technical expertise to make the leap to nuclear weapons is unclear. Nonetheless, most potential adversaries in the region are under the assumption that Japan already has the expertise to go nuclear quickly. It’s been widely claimed in the media that Japan could do so within six months in a crisis, but there isn’t much publicly available evidence supporting this figure. At best, six months may be sufficient for Japan to produce a crude prototype device, but it would be unprecedented to build out the necessary infrastructure, conduct tests, implement safety and training systems and develop at least one viable delivery system so quickly. More credible estimates range from one to even 10 years, underscoring the high number of factors that could influence the timeline. For context, once they had committed to it, both the U.S. and the Soviet Union achieved nuclear status in about four years.

Delivering the Bomb

Japan wouldn’t necessarily need to develop delivery systems with the scale and diversity to rival the largest nuclear powers. In fact, most smaller nuclear powers have sought to avoid getting locked in a Cold War-style arms race. Still, to achieve minimal deterrence – in which the goal is simply to ensure the ability to retaliate against an attacker – Japan over time would likely try to develop its own nuclear triad.

Owing to constitutional constraints on the development of offensive warfare capabilities, Japan does not have any ballistic or cruise missiles, nor any stealth bombers. The Japan Maritime Self-Defense Force, however, has developed some of the world’s most sophisticated submarine technologies. It also has a long history of successful undersea operations dating back to the Cold War, when Japanese submarines played a vital and by all accounts successful role in preventing Soviet counterparts in the Sea of Japan from threatening U.S. positions in the region.

That this is an area of Japanese strength is convenient, since submarines are the most survivable of the three legs of the nuclear triad, and thus would be where Japan may want to focus most. With Japan’s adversaries just a short distance away, land-based missile sites and bomber squadrons would be particularly vulnerable to getting wiped out quickly in a surprise attack.

Though Japan does not have any submarine-launched ballistic or long-range cruise missiles in its arsenal, its Soryu-class submarines are equipped with harpoon anti-ship missiles that, in theory, could be modified to carry a nuclear warhead, as Israel is believed to have done. Regardless, this would be at best a short-term solution. The Soryu-class diesel-electric attack submarines are ideal for defensive combat operations in the crowded confines of the Sea of Japan and East China Sea, and their air-independent propulsion systems enable them to stay submerged for weeks at a time. But the Soryu subs would likely need to be re-engineered to be capable of launching ballistic missiles or longer-range cruise missiles. The range of harpoons is limited to around 80 miles (130 kilometers), and Japan would want to have larger missiles capable of delivering a multiple independently targetable re-entry vehicle (basically a payload carrying multiple warheads that can hit several distinct targets). In addition, nuclear deterrence is greatly improved the longer a submarine can remain submerged. This may compel Japan to start the long-term project of developing its own class of nuclear-powered submarines, which can stay underwater far longer than their diesel-electric counterparts.

To complete the nuclear triad, Japan would need to make substantial leaps forward in both land-based missile and stealth bomber technologies. Neither is likely beyond Japan’s technical capabilities. But because it’s a narrow and dense island nation without much strategic depth, Japan wouldn’t want to rely too much on land-based missiles, which would be among the first targets in a full-blown war. Japan does not have anything akin to North Dakota, home to a heavy concentration of U.S. nuclear-tipped intercontinental ballistic missile silos that are far from major population centers and safe from both earthquakes and sea-based attacks. Nonetheless, it would want to maintain at least a modest arsenal of land-based ballistic missiles, in part because they can respond the quickest among the triad legs. Submarines must contend with communications delays, while aircraft simply take longer than missiles to reach distant targets.

Though Japan does not yet have ballistic or cruise missiles, it is believed to have much of the technology needed to develop them – or even to develop ICBMs, thanks to its experience with satellite launches. Most of Japan’s likely target sets would be within range of shorter-range ballistic missiles, but Tokyo may also want to be able to hit population centers in western Russia and inland China, which would necessitate an ICBM.

Compared to land- and sea-based missiles, aircraft delivery systems would give Tokyo the most flexibility in designing counterstrike scenarios, since they can be redirected to new targets or recalled if the decision to strike is canceled altogether. They can also more easily attack multiple targets. Aircraft can also be used to deter conflict simply by demonstrating their reach while stopping short of attacking (as illustrated by the frequency of recent U.S. B-1 flights over the Korean Peninsula). Perhaps most important, Japan’s burgeoning fleet of F-15s and, especially, the stealthier F-35A (the first of which was deployed late last month) can be modified to carry tactical nukes, potentially giving Japan some breathing room until its missile program starts to bear fruit. Notably, Japan purchased its first aerial refueling tanker in 2008, improving both the range of Japanese warplanes and their ability to avoid being targeted by enemy surface-to-air missiles. And in December, Japanese officials confirmed that Tokyo is planning to equip its fleet of F-35A warplanes with U.S. long-range cruise missiles capable of striking targets as far as 560 miles away – say, ballistic missile launch sites in North Korea – in what would be Tokyo’s first major purchase of offensive weaponry in more than half a century.

Carrying the Cost Burden

It’s hard to gauge the exact costs of a nuclear program, given that spending levels among existing nuclear powers are closely guarded secrets. Costs would also vary widely depending on the scope of the nuclear deterrent Japan chose to pursue, as well as whether it could modify existing weapons systems for nuclear use or would need to develop entirely new systems. Naturally, credible estimates have varied widely as well.

An unconfirmed report in 2006 by the newspaper Sankei, purportedly citing government estimates, claimed that developing Japan’s first prototype would cost about $1.68 billion to $2.52 billion over 3-5 years. According to the NPEC, sustaining a full-fledged nuclear program would cost Japan from as low as $7 billion to as high as $400 billion per decade, depending on the size of the nuclear arsenal and accompanying delivery systems. For context, Japan will spend some $48 billion on defense in 2018 out of an overall government budget of around $860 billion.

Since 1976, Japan has capped military spending at 1 percent of GDP. In 2017, this was still enough to give Japan the world’s eighth-largest military budget, according to the Stockholm International Peace Research Institute. But to sustain at least minimal deterrence, Japan would need to spend far more on its military than it has been for most of the past half century. With the world’s third-largest economy, and one that has proved capable of sustaining enormous levels of spending, Japan almost certainly has the resources to do so if it were deemed a priority. North Korea and Pakistan (albeit apples and oranges compared to Japan) have evidently been successful with less. Notably, last year, Japanese Prime Minister Shinzo Abe formally discarded the 1 percent cap on military spending.

Public Support

Perhaps the biggest hurdle facing Japan is political will. As the only country with any experience getting attacked by a nuclear weapon, Japan has a deep-rooted aversion to nukes. Open advocacy for their development is typically met with public scorn. Following World War II, Japan’s “nuclear allergy” even extended to nuclear power – and unease has remained to the point that, after the Fukushima disaster, the government in 2011 moved to phase out the use of nuclear power altogether by 2040, though this policy was reversed just a year later.

Poll results vary, but they don’t generally suggest that the public is clamoring to go nuclear. A string of surveys in September, for example, showed around 80-90 percent in opposition – even though the polls took place just days after North Korea’s sixth nuclear test and little more than a month after its first successful ICBM test.

Japan would also need to shed major legal constraints to go nuclear, such as its Atomic Energy Basic Law, which bans all but peaceful nuclear activities. (Japan’s “three non-nuclear principles” – that Japan shall neither possess nor manufacture nuclear weapons, nor shall it permit their introduction into Japanese territory – has never formally been made law.) Tokyo is also a signatory of the Treaty on the Non-Proliferation of Nuclear Weapons and the Comprehensive Nuclear Test-Ban Treaty. Withdrawal from those treaties could jeopardize supplies of enriched uranium that Japan would need until it succeeded in closing the fuel cycle.

Potentially most problematic is Article 9 of Japan’s pacifist constitution, which forbids the use of military force for offensive purposes. Thus, any weapons acquired or developed by the military must be deemed intended for defensive purposes. Abe said in 2016 that nuclear weapons wouldn’t violate Article 9 if used only in defensive situations – and several politicians have since echoed this sentiment – but it remains to be seen whether this would survive a legal challenge or the court of public opinion. At a minimum, Article 9 is restricting Japan’s ability to develop or procure the delivery systems needed for an assured second-strike capability.

Laws, of course, can evolve. Japan has reinterpreted elements of its constitution repeatedly since it first rebuilt its military. Abe’s administration approved a reinterpretation of Article 9 in 2014 to grant the military powers to exercise the right of collective self-defense. These changes were formalized through a pair of contentious security laws implemented in 2016. And Japan has been gradually edging into the realm of offensive warfare capabilities anyway. Still, Abe has made it a priority in 2018 to fully amend Article 9 – and his party has the supermajority in the legislature to see the changes through. But such a revision would also need to pass a public referendum. Here, polls are less than favorable, underscoring just how politically contentious Japan’s path to remilitarization is likely to be even if it stops short of nuclear weapons.

It’s hard to gauge how the Japanese public would react to a serious push to go nuclear, in part because such a move would take place only in an environment in which it had become abundantly clear that Japan could not rely on the U.S. for its nuclear deterrent. In such an environment, the public view could be different. Japan, after all, has shown an extraordinary ability to reinvent itself throughout history.

South Korea

Unlike Japan, South Korea has had relatively few qualms about going nuclear, and it likely already would be a nuclear power if it weren’t for the United States. Seoul quietly launched a full-fledged nuclear program in 1971 after the withdrawal of some 26,000 U.S. troops from the country. But the program was still in the early stages when it was shut down in 1975 under pressure from Washington. After the Jimmy Carter administration tried to withdraw from the peninsula completely, Seoul tried again to purchase a reprocessing facility from France, and again it was stopped by Washington. Until 2010, the U.S. – which didn’t want to get dragged into a war – also imposed tight limits on the range of South Korean missiles and the weight of their payloads.

Instead, Washington persuaded Seoul to rely on the hundreds of nuclear weapons the U.S. already had deployed on South Korean soil, which peaked at more than 900 in the 1960s. Following the end of the Cold War in 1991, with long-range strike options having negated the need for deployment on the doorstep of potential adversaries ringing the Korean Peninsula, the U.S. withdrew the entire arsenal.

South Korea has taken advantage of this umbrella to build out one of the world’s most advanced economies and to invest in stout conventional military forces. Still, the South has never felt fully at ease being tied to the United States. And today, it has the capabilities, resources and strategic rationale to classify as a latent nuclear state. Moreover, unlike Japan, the South already has some of the weapons systems in place to achieve minimal deterrence, and it faces much lower domestic resistance to the development of nuclear weapons.

Building the Bomb

South Korea’s ability to rapidly go nuclear is likewise rooted in its civilian nuclear infrastructure. The country has 24 nuclear reactors, with another eight slated to come online before 2029. Among these are four pressurized heavy water reactors, which produce near-weapons-grade plutonium as waste. (President Moon Jae-in is pushing plans to phase out nuclear power altogether by 2060, but it’s doubtful at this point that this policy will survive.)

South Korea imports all the enriched uranium it uses for civilian purposes. There isn’t much available to be mined in the country. And it does not have any known industrial-scale uranium enrichment facilities, which would be needed to have an independent source of weapons-grade highly enriched uranium – and which would be difficult to keep secret. This means South Korea would likely look first to plutonium, which can be obtained by reprocessing spent nuclear fuel. According to a 2015 NPEC report, South Korea already has enough plutonium to produce 4,330 relatively low-yield nukes.

There’s also considerable evidence that South Korea already has the technical expertise to transition from civilian to military nuclear activities. Though the South’s nuclear program shut down in 1975, Seoul admitted in 2004 that scientists with the Korea Atomic Energy Research Institute had been quietly continuing to experiment with fissile material ever since (purportedly without the government’s knowledge), in violation of its international treaty obligations. According to the IAEA, the scientists had demonstrated the capability to extract plutonium from spent fuel (albeit only in small amounts) and enrich uranium up to 77 percent – shy of the 90 percent threshold considered weapons-grade but still theoretically sufficient for a nuclear weapon. Estimates of South Korea’s “breakout time” are similar to Japan’s – and similarly inexact. But a crude prototype is likely well within reach.

It’s important to note that South Korea does not have much of its own uranium, and thus it relies on nuclear fuel provided by members of the Nuclear Suppliers Group, which requires buyers to be signatories of the Treaty on the Non-Proliferation of Nuclear Weapons. If South Korea were to withdraw from the treaty, sourcing nuclear fuel would not become impossible, but it would certainly be made more difficult.

Delivering the Bomb

Like Japan, South Korea would need to consider the type and scale of the nuclear arsenal it wants to build to determine the weapons systems it would need. But unlike Japan, South Korea already has much of the delivery systems it would need to achieve minimum credible deterrence. Going nuclear would, however, change the emphasis somewhat of the country’s military modernization efforts.

For example, South Korea’s rapidly advancing arsenal of Hyunmoo ballistic and cruise missiles, with ranges of 200-950 miles, are believed to be capable of carrying a nuclear warhead. And this arsenal is set to get bigger. Last fall, the U.S. removed restrictions that had capped the range of South Korean missiles at roughly 500 miles and their payload to about 1,100 pounds, freeing the South to develop missiles that are better suited for nuclear purposes. The Hyunmoo-3D supersonic cruise missile in development is expected to have a maximum range of almost 2,000 miles, which would put all but the outer reaches of China within reach. Seoul unveiled plans last year to develop the Hyunmoo-4 ballistic missile, or Frankenmissile, capable of carrying a 1-2 ton nuclear payload. Given South Korea’s proximity to most high-value targets in North Korea, northeastern China and Tokyo, it may not need to develop an ICBM, though it would if it wanted to put all of China and Moscow in range. The South’s recent successes launching a satellite into orbit suggest it has attained much of the necessary technology to produce an ICBM.

Perhaps most notable considering that South Korea is a peninsular country surrounded by potentially hostile maritime powers, the South is also developing a submarine-launched variant of the Hyunmoo-II. This underscores another key element of the South’s preparedness to go nuclear: its fleet of advanced submarines and deep experience with undersea operations. Most important of this fleet is the Jangbogo-III class of submarines currently under construction. They are expected to be able to carry 10 Hyunmoo-3C cruise missiles and an unknown number of submarine-launched ballistic missiles. Last fall, Moon and U.S. President Donald Trump reportedly discussed the South buying or jointly developing nuclear-powered submarines from the U.S. The main advantage of nuclear-powered subs over their faster, quieter diesel counterparts is that they can stay underwater for much longer — a valuable feature in nuclear deterrence.

South Korea does not have any strategic bombers, but it does have a number of fighters, including a growing fleet of F-15s, F-16s and F-35s, that could be fitted to deliver small nukes akin to the U.S. B-61, which boasts a variable yield of 0.3 to 340 kilotons. (The bomb used in Hiroshima had a yield of around 15 kilotons.) The South also has an advanced aviation industry and likely has the capability to develop strategic bombers over time. The South also has begun acquiring aerial refueling aircraft.

Carrying the Cost Burden

Once again, accurate estimates on potential nuclear spending are elusive. South Korea may be able to spend less than Japan, given its existing missile and submarine assets, but the total cost burden would again depend on an array of factors.

What is clear is that South Korea has the world’s 11th-largest economy, with a 2017 GDP of $1.4 trillion. And it has the world’s 10th-largest military budget. Unlike Japan, South Korea has routinely spent far more than 1 percent of its GDP on its military, including 2.7 percent last year. In a scenario in which the U.S. exits the peninsula completely, there would be a high number of competing budgetary priorities. Nonetheless, it’s safe to assume the South could carry the cost burden of going nuclear if doing so became a priority.

But there may be heavy ancillary economic costs to going nuclear if doing so leads to international sanctions or jeopardizes trade relationships. Moreover, as noted above, withdrawing from the Non-Proliferation Treaty would jeopardize the South’s supply of uranium, almost certainly harming its civilian nuclear power sector and forcing the country to either seek higher-cost fuel sources or bite the bullet and switch away from nuclear energy. It would also undermine South Korea’s plans to become a major exporter of civilian nuclear technologies at a time when it’s been gaining a foothold in Middle Eastern markets.

Public Support

South Korea does not have an overwhelming aversion to the development of nuclear weapons. Polls vary, with public support generally increasing during times of greater tension with North Korea. But a Gallup poll from September found that around 60 percent of South Koreans support going nuclear — a figure that’s roughly in line with the historical trend, even though the poll was taken shortly after North Korea’s sixth nuclear test.

Accordingly, the question of whether to pursue nuclear weapons is a regular topic of public debate. Conservative political parties — which usually dominate South Korean politics – and ideologically aligned media routinely make the public case for becoming a full-fledged nuclear state or, at minimum, redeploying U.S. tactical nukes on the peninsula. Once in office, South Korean leaders have generally been much more circumspect about this prospect, but likely not because of overwhelming political pressure from opponents of going nuclear.

Strategic Risks and Rationale

Both Japan and South Korea are trapped in something of a strategic paradox. They do not have nuclear weapons, but because of their latent breakout ability and their tight alliance with the U.S., their neighbors are behaving in many ways as if they do.

Both countries are investing heavily in stiffening their defenses against a possible attack, particularly through sophisticated anti-ballistic missile systems. Japan is primarily procuring sea- and land-based U.S. systems such as Aegis, some of them jointly developed. South Korea, in comparison, is focusing on indigenous land-based systems, while also allowing the U.S. to expand deployments of advanced systems such as Terminal High Altitude Area Defense. But even the most advanced ballistic missile defense systems are still far too unreliable to build a strategic doctrine around. South Korea has also invested heavily in missiles capable of striking, say, a North Korean launch site if a nuclear attack were deemed imminent – and Japan appears primed to follow suit. But these too are unlikely to fully eliminate the threat posed by North Korea. They certainly would not mitigate the much more expansive Chinese nuclear capabilities. In short, both Japan and South Korea need nuclear deterrence. And for now, that means they need the United States.

But to whatever degree Japan and South Korea believe that the U.S. would respond on their behalf if attacked, they cannot be fully confident that the U.S. would be willing to put its own cities at risk to do so – particularly as adversaries develop increasingly long-range strike capabilities. Moreover, as the current Korean crisis illustrated, both countries – but Japan, in particular – have little freedom of action when it comes to shaping regional events. Japan could not, for example, launch an attack on North Korea unilaterally if the U.S. opposed it, nor could it use the threat of such an attack to gain leverage at the negotiating table. We think South Korea has dissuaded the U.S. from going to war with the North, but it realizes it would not be able to stop the U.S. from launching military operations in the North if it resolved to do so, despite the risk of a devastating counterattack on Seoul.

So it’s not hard to imagine scenarios in which core interests between the U.S. and either of its two stalwart allies in Northeast Asia diverge to the point where Japan or South Korea decides U.S. guarantees are no longer enough. There doesn’t even need to be a full break in the alliance for this to happen (as the U.K. and France demonstrated when they went nuclear in the 1950s and 1960s despite being members of NATO), and there are plausible scenarios in which the U.S. would even support such a move. Japan and South Korea’s other option is to opt for an Israeli-style nuclear doctrine of “strategic ambiguity,” where the country’s nuclear program reaches fruition but is never declared publicly.

Still, capability is only part of the strategic calculus, and the risks of going nuclear for either country shouldn’t be underestimated. If either Japan or South Korea developed nuclear weapons, it would almost certainly escalate the regional arms race (starting with the other of the two following suit), raising the risk of accident and miscalculation while eroding nonproliferation efforts globally. The domestic political backlash, particularly in Japan, could be immense and destabilizing, to say nothing of the international diplomatic and economic repercussions. If it weren’t already at that point, the diplomatic approach to denuclearizing North Korea would be finished. Meanwhile, going nuclear might also weaken U.S. attention to the needs of either country. Even if South Korea and Japan no longer needed the U.S. nuclear umbrella and were less tied to U.S. direct interests, the U.S. would likely remain incomparably powerful and uniquely handy in a crisis.

For either to go nuclear would mark a profound departure from a status quo that has, in most ways, enormously benefited both South Korea and Japan. Any such decision would presumably be done only reluctantly, and in recognition that the status quo is fundamentally no longer tenable.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.